Are We Seeing Housing Market Manipulation?

While I generally agree that artificially propping up asset prices is not a sustainable idea, I am not sure that I would agree that attempting to bring 30yr fixed conforming mortgages down to 4.5% would qualify as artificial manipulation. I also feel that the effect which 4.5% mortgage rates will have on the housing market is a topic wide open for debate with little concrete data to back it.

First let's examine the nature of 30 year fixed mortgage rates. These rates are set by the market in relation to the rates of 10yr treasury bonds. The typical spread between 10yr treasuries and conforming 30yr fixed loans is about 110 to 175 basis points. With 10 year bond rates below 3%, that would imply a 30yr fixed rate in the neighborhood of 4.25%. However, with the incredible and hopefully temporary level of extreme risk aversion in the credit markets, this spread has almost doubled.

The underlying message being sent by the market is that it is demanding a larger risk premium for holding mortgage paper instead of treasuries. The reason behind this message is clear - defaults are rising and the credit quality of the bonds is being questioned. The underlying causes for this include economic conditions, house price depreciation and, in my opinion most important of all, underwriting standards.

The reason that I put underwriting standards at the top of the list is the fact that it is future loans which are being priced and not the loans already out in the marketplace. Underwriting standards have changed significantly, with the most important change being the elimination of Stated Income and other alternative forms of income documentation (for a good explanation of all of the various flavors of exotic mortgages please take a look at www.ml-implode.com) or "liar loans." The spread between these mortgages and 10 year treasuries has widened so dramatically and the target rate has been set slightly above the historic norm.

When the plan was announced last week, 10 year treasury yield was below 2.7%, so the proposed artificial spread would be over 180bips or a bit above the historic norm. This means that the government is not attempting to artificially lower risk pricing below a level which the market has defined as sustainable. It is a key metric in the measure of the appropriately of any government intervention. If the standard intended to be maintained via intervention is indeed significantly outside of the historic norm, then it is unlikely to be sustainable or effective over the long term. On the other hand if the level which the intervention is meant to maintain is itself within the historic norm and is being supported during a time of crisis, the response seems measured and appropriate.

The second issue at hand is the effect that such a manipulation of interest rates will have on the housing market. The first component of this issue is the real effect on mortgage payments that a drop from 5.5% to 4.5% truly means. At 5.5% a borrower has to pay $5.68 per $1000 borrowed, and at 4.5% the payment drops to $5.07. So an 18.18% drop in mortgage rate only leads to a 10.74% reduction in payment.

Another component in determining the effectiveness of mortgage rate reduction in stimulating the demand for and price of housing is the effect that this will have on homebuyers' ability to obtain credit. While the payment reduction will mean that every dollar of income can now be used to qualify for more mortgage, it does not in any way help borrowers come up with down payments or qualify for credit standards.

These are very important components, and the elimination of down payments and deterioration of credit standards are in my opinion what drove the bubble. These were the factors that allowed borrowers to borrow more than they could ever hope to pay back. When borrowers have to come up with down payments and prove their credit worthiness, they are rarely allowed to buy significantly more than they can afford as the elimination of this situation is the very goal of credit standards and definition of credit worthiness.

Because down payments and documentation of income are now required and debt ratios have been lowered to more sustainable standards, non-credit worthy borrowers have been driven out of the market. Simply making purchase mortgages 10% cheaper in real terms is unlikely to have a huge impact on the unwinding of speculative excess from the housing market. The seemingly temporary lowering of mortgage rates is more likely to have a significant psychological impact on qualified potential homebuyers who see it as being a more meaningful reduction in ownership cost than it really is. This would have a positive and sustainable effect in stimulating housing demand by encouraging sustainable buying and turning market sentiment towards buying.

It is exactly these encouragements combined with sustainable credit standards which are needed to spark a long standing recovery. It is also the role of credit standards to keep unqualified borrowers out of the market in order to keep buying down to a sustainable level and prevent an overheated bubble from redeveloping.

Stock position: None.

Comments

[sickofthehype:]

The issue: Foreclosures and high inventory, which are bringing down everyone's home values.

Solution: Get rid of them

How? 4% 30-yr rates will clear this inventory out LIKE NO OTHER.

Then: Once they're mostly flushed from the system inventory levels as a number and as of composition (not majority bank owned) will get things to normal

2008 Dec 08 09:54 AM

[Philip Gvinter:]

I don't think that 4% rates will clear inventory but they will help to some degree and most important of all to a degree that will not lead to a bubble forming on the way out.


On Dec 08 09:54 AM sickofthehype wrote:

> The issue: Foreclosures and high inventory, which are bringing down
> everyone's home values.
>
> Solution: Get rid of them
>
> How? 4% 30-yr rates will clear this inventory out LIKE NO OTHER.

>
>
> Then: Once they're mostly flushed from the system inventory levels
> as a number and as of composition (not majority bank owned) will
> get things to normal

2008 Dec 08 10:29 AM

[Drew Horn:]

The assumption Mr. Gvinter makes is the objective should be to artificially "support" house prices. I disagree! Those with median incomes cant afford houses at the median price. It isn't practical to continue to prop up prices at unaffordable levels.

The assumption about the merit of supporting current house prices has an analogy in education. The price of college tuition has risen to the point that students and their families cant afford to purchase an education. There is no moral or economic justification for current tuition costs and efforts to maintain them should not be made.

The market should set prices, not Henry Paulson.

2008 Dec 08 11:33 AM

[Joe in Chicago:]

Who exactly is going to run out and buy a house with all these cheap mortgages? People who can afford a house already own one. And most would not be interested in relocating, today, unless they lived in a recession-proof market and could avoid a loss.

The majority of people in a position to buy are first-time home owners. And how many of them have down payment money or outstanding credit scores? How much of a dent would they really make?

No the real answer is market forces: foreclosures, a MAJOR correction in real estate values and a long, slow recovery period. Given the recessionary economy and increasing unemployment, the chance we'll see a recovery in real estate before 2010 seems slim to none.

2008 Dec 08 12:19 PM

[BerkeleyBob:]

Good article. Bad underwriting, unrealistic appraisals and the aiding and abetting of toxic loans by the credit rating agencies had a lot to do with the present unpleasantness. The NAR says the average home owner moves within 7 years after purchase, so maybe a fixed 30 year term is rarely carried to payoff. Certainly, a return to sound underwriting is necessary, and price correction inevitable but if I recall correctly, the S&L crisis came about because of a political decision to fund a war in Vietnam and against poverty at the same time by deficit financing--we could again see a crisis if interest rates increase and you can bet the lenders who are holding fixed interest rates loans will want relief.

2008 Dec 08 12:20 PM

[Philip Gvinter:]

Actually my point is that this is the only action taken which will not artificially support housing prices. The point here is that systemic norms have been violated. This is really more about returning the mortgage market back to a reasonable level of functionality in order to encourage some buyers to look. Lower mortgage rates may have a significant psychological effect in encouraging buyers to look but in the end tough underwriting standards will keep many of them away anyway. Prices must absolutely correct back to where median income can support median price.

2008 Dec 08 12:36 PM

[nym:]

"Prices must absolutely correct back to where median income can support median price." This would come as quite a shock to metro areas of California, where price/income > 5 for decades while most of country is 3 to 4. How can this be supported? I suspect that most "owners" make minimal payments and are thus little more than a peculiar type of renter with rights to a capital gain (or default) when they roll over into another house priced with a gain built in.

2008 Dec 08 12:58 PM

[Philip Gvinter:]

While the price to income ratio varies around the country it still has a historically sustainable range in every market. California is certainly a more highly leveraged market than the mid west and both need to return to their individual historic price-income ratios.


On Dec 08 12:58 PM nym wrote:

> "Prices must absolutely correct back to where median income can support
> median price." This would come as quite a shock to metro areas of
> California, where price/income > 5 for decades while most of country
> is 3 to 4. How can this be supported? I suspect that most "owners"
> make minimal payments and are thus little more than a peculiar type
> of renter with rights to a capital gain (or default) when they roll
> over into another house priced with a gain built in.

2008 Dec 08 03:24 PM

[Did U Think...:]

Smart people will not buy until values come down to a level where the unaided free market will support the price and 4% interest rates are not going to affect that one little bit. There is nothing the gov't can do but let the market correct the excesses.

2008 Dec 09 07:53 AM